Global Bond Market "Canary"! Pressurized Japanese government bonds will be the first "domino" to fall?

As interest rates rise and the Bank of Japan gradually stops buying bonds, Japan is facing a dual challenge of structural debt and inflation. The rise in Japanese government bond yields could disrupt global bond markets, and potential capital outflows could affect US government bonds. Japan's ability to repay debt through inflation is constrained by slow real economic growth and an aging population, raising concerns about the reappearance of financial repression. Despite a weak currency and rising yields, Japanese stock markets and gold (priced in yen) have performed well, reflecting a global repricing of assets as governments seek to reduce debt through inflation. Japanese bond yields and the yen exchange rate are trending higher For decades, Japan has been in an environment of near-zero interest rates, suppressed volatility, and long-term deflation, but this situation has quickly changed. In addition to the unwinding of yen carry trades, Japan's problem lies in structural debt and inflation, a problem that may soon also plague other advanced markets, including the United States. Japan may be the first domino to fall. Japan's entire fiscal and monetary system is built on the assumption of permanently low interest rates, and this monetary experiment may be coming to an end - Japanese government bond yields are rising. Some investors believe that if Japanese bond yields converge completely with or exceed US bond yields, it could "crush" the global bond market. Japan's debt-to-GDP ratio exceeds 200%, while the US debt-to-GDP ratio is close to 120%. Both of these figures are historically high and problematic, with the size difference being crucial. Governments repay debt through tax revenue generated by the economy. When debt grows far faster than economic output, even a slight rise in interest rates may exceed fiscal capacity. In Japan's case, a significant portion of annual government expenditure is already used to repay debt. Higher yields will quickly crowd out all other expenses. This could further push up Japanese government bond yields. For over two decades, Japan has been plagued by deflation. This has allowed the government to borrow on a large scale at very low rates without producing any direct consequences. Now, the macroeconomic backdrop has changed. Over the past three years, Japan's average inflation rate has been around 3%. Although this number may seem small compared to recent experiences in the United States or Europe, for Japan, it is a profound shift. Low inflation made aggressive monetary easing policy safe and eventually became the core of the now famous yen carry trade. Can Japan escape debt through economic growth? This is a key question. It is reasonable to believe that Japan can reduce the debt burden brought by inflation by increasing nominal GDP, but the country also faces some challenges. Since the vast majority of Japan's debt is denominated in yen and held domestically, policymakers in Japan have greater control compared to countries that rely on foreign capital. If the inflation rate can be maintained in the range of 2% to 3%, the nominal GDP growth rate will rise, tax revenue will increase, and the real value of existing debt will gradually decrease. However, due to aging population, sluggish productivity growth, and limited immigration, Japan's structural growth is slow. Inflation without real economic growth could raise costs without significantly expanding the tax base. At the same time, the rising bond yields threaten the entire strategy. Japan can only escape the predicament through inflation, provided that interest rates remain below the nominal growth rate, which the current market is reacting to. If yields rise too high, it may lead to the reemergence of yield-suppression policies. The Bank of Japan may resume bond purchases, and may even require commercial banks to take on more sovereign debt. Why is this important for the US and the world? Some investors believe that if Japanese bond yields converge completely with or exceed US bond yields, it could "crush" the global bond market. Although estimates of the scale of yen carry trades vary, it is widely believed to be at least $500 billion, providing strong support for the rise in global financial markets, which will inevitably impact global financial markets if unwound. This is crucial for the US and US investors for two main reasons. Japan is the largest buyer of US government bonds, holding over $1 trillion. Instability in the Japanese bond market could spill over into the US market. In other words, a rise in Japanese government bond yields may encourage domestic investors to repatriate funds, sell US government bonds, and buy Japanese government bonds. As the anchor for asset pricing, a surge in US bond yields is likely to impact global markets. For years, the Bank of Japan has played the role of the final buyer of Japanese government bonds, suppressing yields through large-scale quantitative easing policies. At its peak, the Bank of Japan held an astounding share of Japanese government bonds. Once inflation occurs, this strategy becomes unsustainable, especially as the yen begins to depreciate. In an inflationary environment, printing money to buy bonds poses the risk of currency instability and loss of market confidence. Therefore, the Bank of Japan is forced to tighten monetary policy, even recently reducing the size of its balance sheet. Logically, when the largest buyer exits the market, prices will fall and yields will rise. Interestingly, even with higher yields, the performance of the Nikkei Index is better than the S&P 500 Index. On one hand, inflation has actually stimulated the Japanese economy, with hopes that wages and income will begin to grow. Of course, as the yen continues to depreciate, returns will increase at least in nominal terms. This is why, ultimately, as governments around the world strive to reduce debt, both hard and financial assets will perform well. But perhaps more importantly, Japan essentially shows what the future of the US could look like. While the US debt burden is not as heavy, deficits are still a problem, and the US government will try to alleviate the debt burden through inflation. Japan will be the "patient zero" as it tries to do so.